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The Theory Strikes Back

In November of last year, an economic research paper appeared on the website of the European Commission’s Economic and Financial Affairs section entitled The euro: It can’t happen, It’s a bad idea, It won’t last. US economists on the EMU, 1989-2002. It’s by Lars Jonung and Eoin Drea. There are 2 ways to read it.

One is an intellectual history of the attitudes of US-based economists to the Eurozone project from inception to it being up and running. The second is, as the Americans would say, a spike of the football in the endzone in the faces of the defensive players after a touchdown has been scored (“We find it surprising that economists living in and benefiting from a large monetary union like that of the US dollar were so sceptical of monetary unification in Europe”). In other words: the Euro worked, and the American economists thought it wouldn’t. And the title suggests that some element of the 2nd reading is intended.

Now one awkward thing about this is the timing. November 2009 was not exactly the time to be claiming that silly American economists were too wedded to optimal currency area theory to see the wisdom of the Eurozone. But instead of belaboring this point, take a look at another superb Martin Wolf column in the FT and his bracing conclusion –

When the eurozone was created, a huge literature emerged on whether it was an optimal currency union. We know now it was not. We are about to find out whether this matters.

And whether that matters is ultimately a political decision. To dig into the pop culture well, the US-based economists who form the sample in the Jonung-Drea paper were giving the Star Trek answer: “Damn it Jim I’m an economist not a politician.” Looking at the predicament of Ireland, Greece, Spain, Portugal, and Italy, they may still be right.

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24 thoughts on “The Theory Strikes Back”

I have been following the whole euro story on Afoe. And I am starting to wonder, what was the point?

Apparently, plenty of economists(not only American)knew that they were a few inherent problems in the idea of a monetary union.But the project went forward anyway. Why?

So far, I am aware of only one explanation. The eurozone was a political project and economic reality didn’t matter. Or somehow, somebody thought it wouldn’t matter because the introduction of the euro would be followed by the integration of national economic policies( which never happened).

Multicolor bills sure are pretty but I would like to believe that a more rational explanation exists somewhere…

What would have happened if there were no euro? The credit bubble of the 00′s would not have inflated or would have been much smaller. At the end of the decade, European economies would face currency volatilities and somewhat higher interest rates, but without the bubble burst and without the Great Recession. Ireland, Spain and Greece would be saved from the aftermath of cheap money-induced booms and subsequent implosions.

The whole “not economic but political” meme runs through the EU from top to bottom. For an enterprise that was supposed to revitalise the European economy, it has not done so well. From 2% unemployment, 5% growth, and rough fiscal balance in the sixties, we now accept 9% unemployment, 1-2% growth and massive fiscal deficits as the new normal. And those conditions precede the current crisis.

We were told that political union was a price worth paying for economic growth, but now we seem to be saying the sub-par economic performance is a price worth paying for political union.

Your reading is that the euro is on net a negative during this crisis because it makes monetary policy less effective as a means of economic management – The problem with this reading is that without the 900 kilogram gorrilla of the common currency standing guard, Ireland would be Iceland. as would Greece, and possibly Spain. The bubbles would have been popped earlier, yes. – but not much earlier, and they would have been popped by hedgefunds running speculative attacks on the independant currencies of the bubbly economies, which is an extraordinarily destructive way to unwind a bubble. (see also: The asian currency runs that inspired china to start piling up an infinite pile of dollars to avoid this fate..) The euro is currently working the way it is intended to in a crisis, by shielding national economies from the (over)reactions of the market while the wreckage of the crisis is dealt with. Whether said wreckage is actually dealt with well is down to the national politicians, but there are limits for what a currency union can accomplish – it cannot automagically make the politicians of its units into virteous and clever people. See also: California.

Don’t forget there were a lot of implicit trade offs in member States agreeing to the Euro: chief among them Germany getting a greater role in EU foreign affairs and an overall objective for the ECB closely modeled on the Bundesbank. Its an incremental process of course, the euro area will not function optimally until further economic integration takes place. The Jonung Drea paper shows that many U.S. economists understood this.

I find the comment that the euro is “shielding” countries from market reactions to deficits quite interesting.

I think an equally valid interpretation is that the countries on the periphery of Europe used to welcome devaluation as a way to redress imbalances, and that what we are seeing today is the consequences of not allowing the market to do its thing.

Locking the PIGS into the Euro was fine in theory; if they could not devalue they would have to become more efficient, but in practice it seems that they cannot become more efficient as quickly as the market used to act.

I joked the other day that in this crisis the Italians have the difficult job of becoming Germans while the British have the easier job of becoming Thatcherites once again.

No, they need to unlearn certain aspects of Thatcherism. The UK is overspecialized in financial services and housing. This is not a clever economic policy (see: well. Iceland! and Spain.) and what is really needed is a bit of a leaf from the french manual and some dirigiste prodding of the economy in high-productivity directions other than finance. Labours parting gifts to the next administration are a good start, but may not suffice –
New nukes, punitive taxing of finance bonuses, and infrastructure planning reglation streamlining says “We are certain we are going to loose the next election no matter what, so we are going to do some things that are good policy but bad politics before we get kicked.”

The growth of the financial sector was a side-effect of removing restrictive practices in the City. It was not, by itself, a deliberate Government policy; although I doubt if Thatcher regretted seeing it happen.

The UK is naturally a financial centre for reasons of location, language, expertise and history. Financial services “invent themselves” in the UK, in much the same way that Capitalism invents itself, and has to be suppressed if you don’t care for it.

Much the same is true of manufacturing. Unless you want to go back to the days when the taxpayer subsidised the UK manufacturing sector, it must grow or shrink on its own merits. Personally, I cannot conceive of a UK that can compete with China in the production of cheap underpants, but it’s pretty clear that the UK can compete with anyone in aerospace, drugs, petrochemicals and a bunch of other manufacturing sectors. In other words, we have the manufacturing sector that our labour costs can support – mostly mid- and high-tech – and that is something that is hard to change. Our education system, thanks to Labour, is the problem here.

As for taking a leaf from the French, their debt level was about half again as large as the UK’s (66% v. 44%) before this crisis ever started – which means that indirectly they were subsidising manufacturing – and their debt level is projected to be almost the same as the UK’s in 2014. So it looks to me that dirigism is pretty much a wash here. If you practice Colbertism, or if you let the market take care of things, you end up pretty much in the same place.

But that’s what we would expect, isn’t it? Legislation can move wealth around, but legislation by itself produces no extra wealth.

So my conclusion is that we do indeed have to get back to Thatcherism; cut the size of Government, reduce regulation and direction, and cut back on Labour’s market-rigging. Since it has worked once – an existence proof – I would need convincing that it would not work again.

It is hilarious to observe that the UK is a natural financial centre, while any view at history would show it was North-Italy during the Renaissance period, Augsburg in the 16th, Amsterdam in the 17th and 18th century and the UK in the 19th, after which it was overtaken by Wall Street in the 20th. There is nothing natural about a financial centre.

Italians don’t need to become Germans, instead they should start mimicking the strategies executed in Austria and The Netherlands to improve their position vis-Ã -vis Germany, when they linked their currencies to the Deutschmark: freeze salaries.

The second approach is to modernise industry fast. This is doable in Italy in some sectors of industry, but will cause an internal further rift between the North and the South.

Spain has a similar problem set, as their productive industrial base is in the Basque and Catalan regions. There is still a huge internal economic difference with the tourism driven south and east-coast areas and Madrid siphoning off regional created wealth via tax flows.

Portugal may have a way out by strengthening its ties with Brasil.

Ireland runs a huge current account surplus and just has to grasp that their taxes (in particular corporate taxes) are too low. Together with some selective budget cuts and programs to finally start improve their infrastructure outside the Greater Dublin area, they may rapidly return to prosperity, as there aren’t too severe fundamental economic problems with such a huge amounts of money flowing in from export surpluses. It is more distributional.

The real problem case is Greece. A country where the governments cooked the state ledger to join the Eurozone. Governments that then enjoyed reduced interests for state bonds, but didn’t spend their increased discretionary budget well on rapidly improving productivity in Grecian business.

As Greece doesn’t have historic economic ties like Portugal (Brasil) and Spain (Latin America), except with Turkey which they try to avoid, there are no easy political ways out. A massive change in attitude vis-Ã -vis Turkey would restore confidence in Greece’s future. E.g. businesses who may want to serve the Turkish market could setup in Greece savely in the Eurozone. The real risk for Greece is that Bulgaria may adopt that strategy instead after it integrates deeper with the Eurozone. In that case they genuinely have blown it.

And then proceeds to demonstrate the reverse. Isn’t it clear that if you take the four criteria I listed, they illustrate pretty directly why the world financial centres move over time? When Italy was the centre, Italy was the source of finance for much of Europe, and so on until in the 20th Century we get London and New York neck and neck.

What has changed since the days of the Italian Bankers is that we have a globalised economy and 24hr financing. What does that get you but London, Tokyo and New York?

I’d bet money that in the next couple of decades the Asian pole of finance will begin to move from Tokyo to Beijing, and that, by any reasonable meaning for the word, will be perfectly natural.

“Italians donâ€™t need to become Germans, instead they should start mimicking the strategies executed in Austria….”

Which is what I mean by “becoming German”.

However, dull literalism aside, the rest of this post has some problems. When you airily say “Portugal may have a way out by strengthening its ties with Brasil.” doesn’t that invite the question why they have not done so already? After all, it’s not as if Brazil was discovered yesterday, is it?

When someone says Portugal can do this or can do that, it’s worth noting that Portugal entered the EU with a GDP/head 75% of the EU average, and that is where it has been stuck ever since.

Sure, countries “can” attempt to converge their economic efficiency with that of Germany, but since this is a long-standing problem for them, why should we imagine it is easy or simple to do today, when it has not been done in the past.

And I can’t resist adding that this is what we always hear about the EU. It’s always jam tomorrow, but somehow tomorrow never seems to come. Meanwhile unemployment creeps up, divergences don’t seem to go away, growth slows down, and fiscal deficits worsen. And people say “well we can do this, and we can do that.”

And finally, I am really not sure if Greece is the real problem case. Maybe Greece is just an early indicator, and the rot is about to spread. I am a little bit nervous that Greece may be a small enough economy that the EU can fix Greece by brute force – by a guarantee or an injection of liquidity, say – only to find later that it only fixed a symptom and left the real problem unaddressed.

Why do economists always expect immediate adjustment from one equilibria to another, without any transition period? Real economy is not a comparative statics and most fun is in understanding the transition from one steady state to another.
The transition of former communist countries towards the European mainstream of market economy and democracy took about 15 years in the most successful cases and is still ongoing after 20 years in some new EU members. Building political and economic safeguards to prevent asymmetric crises and to deal with their aftermath is a social process comparable to transition. It needs more time to digest the experience from the first crisis it found itself in.
Moreover, it is not obvious that the EU periphery would be any better, if they still had their own currencies. After long period of stability they would pile up loans in DM instead of EUR and faced the same dilemma as Latvia, which has ‘independent’ currency, but needs to devaluate internally as if it had euro. The periphery with euro can at least hope for some largesse of the core countries…